Citigroup vs. Twitter: Cash Flow vs. Earnings!

To the delight and astonishment of the entire financial world, the stock market soared 10% during an incredible four day rally last week. The press attributed this sudden burst of optimism to Citigroup’s unexpected announcement that they actually managed to earn a profit during the first two months of 2009. But market analysts remain worried about the possibility of a Citigroup bankruptcy in the near future.

Profitable, but still going bankrupt? How is that possible?

If that sounds strange to you, consider the fiscal status of a very different firm, one that has never turned a profit in its existence, and yet one that is swimming in cash. Evan Williams, the co-founder of Twitter, has publicly acknowledged that his micro-blogging service is slow to turn on its revenue-generating engines. But just last month, a large investor assured the financial markets that “We have a ton of cash. We have far more cash than we need, so I’m not in any hurry.”

Huh? Citigroup is profitable, and yet is going bankrupt. And Twitter is unprofitable, and yet is swimming in cash. What does it mean to be profitable, anyway?

The fundamental answer to this question can be found at the very heart of our centuries old accounting model. And true insight regarding such matters can often be gleaned by engaging in some simple back-of-the-envelope arithmetic.

Profitable Yet Bankrupt: A Sample Illustration

Let’s assume that a seemingly healthy retailer begins the year with the following strong balance sheet ($s in millions):

Now let’s assume that it sells $10 million (retail value) of inventory each month and purchases $7 million (cost value) of inventory to replace it. Its customers all buy on credit and take three months to pay their invoices; thus, there are no receivable write-offs whatsoever. Inventory generally sits in stock for two months until it is purchased by customers; thus, there are no inventory write-offs either.

To maintain its policy of fiscal conservatism, the firm pays down 50% of its vendor payables and 75% of its bank loan during the year. And to maintain the value of its rapidly depreciating (at a rate of $5 million annually) building, it spends $20 million at year-end on a series of renovations that prepare the store for future growth. Furthermore, the bank that carries its loan has offered a simple interest arrangement; it charges an annual interest fee of 10% on any balance that is owed at year-end. Finally, the firm pays $1 million per month in rent to lease its facilities.

Based on this information, the preliminary year-end balance sheet is:

And the preliminary income statement is:

Good news! The retailer is highly profitable. It earns $18 million on sales of $120 million, a highly impressive net margin of 15%. Thus, its equity value soars from $40 million to $58 million during the year, a spectacular 45% gain.

So what’s the problem? Well, the problem isn’t a matter of profitability; it’s a matter of cash flow. Here is how the cash flow worksheet translates into the statement of cash flows; this statement is required to produce the cash balance that plugs into the following year end balance sheet:

And thus the full picture emerges. Yes, the retailer begins the year with $50 million in cash and ends the year with a healthy profit. But it also ends the year with a bank balance that is overdrawn by $1 million, spelling a catastrophic bankruptcy.

How Can This Be Possible?

How can this be possible, you ask? True insight lies in the cash flow worksheet, the output of an accounting model that has not changed since the medieval monk Luca Pacioli first presented it to the world in 1494.

Sure, the firm begins the year with $50 million in cash. It then earns $18 million, which is actually $23 in cash earnings because the $18 million value is depressed by a non-cash expense of $5 million. Depreciation doesn’t trigger any cash disbursements, y’know!

On an operational basis, though, it allows receivables and inventory to creep up by $10 million and $4 million, respectively. Whenever customers take longer to pay their bills, and whenever inventory piles up on shelves, cash flow suffers the consequences. And furthermore, the firm decides to pay down its vendor payable balance by $10 million; its vendor may have appreciated this decision, but cash flow suffers the consequences yet again. So the retailer may earn cash income of $23 million, but it fritters away $24 million, producing an overall operating cash flow loss of $1 million.

Is that a big deal? You might think not, considering that the retailer begins the year with $50 million in the bank. Why doesn’t it end the year with $49 million?

Look again at the statement of cash flows. The retailer may only be losing $1 million on operations, but it also spends $20 million on renovations and $30 million on loan repayments.  Thus, its entire beginning cash balance of $50 million is spent on its investing and financing needs, and its $1 million in operating cash losses ends up throwing the firm into bankruptcy.

Drip, drip, drip …

Why would a firm decide to pay down debt and invest in renovations when it is in the process of going bankrupt? Such incongruities often occur as an unavoidable result of poor timing. Bank repayment schedules and other financing decisions must often be finalized months or even years in advance; major capital improvement projects also demand significant advance planning activities to address zoning, construction, and other issues. Thus, our illustrative retailing firm might well have made their debt and renovation spending commitments long before an unexpected economic slump drove up their receivables and inventory balances.

The “bottom line,” though, is that earnings and cash flow are two entirely different concepts. An organization can earn significant profits and still go bankrupt. Conversely, it can incur significant losses and still have “a ton of cash.” And in the case of our illustrative example, it can make ostensibly reasonable commitments to invest in its future growth, and then watch with horror as the drip, drip, drip of working capital melting away drives their firm into bankruptcy.

The solution to this problem lies in the practical application of enterprise risk management, a process that we described in our January 12, 2009 posting regarding Citigroup. We all know, though, that a firm cannot last forever in an unprofitable condition; Evan Williams of Twitter might thus be wise to review our previous posting!